by Robert Waldmann
Brad DeLong clears his throat. I throw a cow.
The win-win benefits of trading money for money–where are they? It turns out that they are there. There are, actually, four:
1. Trading money now for money later: people who want to save now and spend later can make win-win trades with people who want to spend now and save later.
2. Risk: people who are unusually averse to risk in general can make win-win trades by trading off some of the risks that they are bearing to people who are unusually tolerant of risk in general.
3. Insurance: people who are holding a lot of one big risk can reduce the risk of catastrophic loss by paying a great many others to each take a small piece of that risk.
4. Information: people who have information that prices are going to rise can make win-win deals with people who have information that prices are going to fall–although here the win-win is not for the participants in the trade: for them it is zero-sum, and the winners are those others who observe the market price at which the trades occur.
Ahem. Your fourth win-win “Information:” is not like the others. You redefined win-win to mean “socially desirable” and decide that, if a third party wins, it is a win-win. Also, as you understood when you were in high school and Grossman and Hart figured out when you were in college, information does not explain trading. If the only differences across people were that they had different information then trades couldn’t be win-wins. If it were common knowledge that everyone is rational then trades couldn’t occur. It is not unusual for someone in a type 4 trade to think they are in some other sort of trade. In *theory* there are no type 4 trades which are known to be type 4 trades. Obviously in reality there are such trades.
Now, obviously, trading volumes can not be explained by trades of types 1 through 3. Similarly the amount of CDSs written can’t be explained that way, since it is vastly greater than the amount of assets on which CDSs were written.. I think actually that this is a highly relevant problem. I’m not sure that you can explain the existence synthetic CDOs without type 4 trading which is known to be type 4 trading.
Obviously not everyone is rational (who ever thought everyone was). In particular, there is a group which keeps writing papers which correspond to actual financial markets and keeps being ignored. I forget who they are, but they have created a subfield of Lake Wobegone finance in which everyone thinks they are relatively more informed than they are. Obviously this is what’s normally happening — traders think their trades are profitable, because they think the traders on the other side are irrational.
Goldman Sachs claim that people always know there is a short seller in “such trades” refers to synthetic CDOs not all CDOs. One case of someone with exposure to mortgage default risk who wants to shed it is that someone owns an RMBS and wants to insure it. That agent could just buy Treasuries and sell the RMBS to form a normal non synthetic CDO. I can imagine other people trying to shed a correlated risk — construction firms and construction workers should have bought RMBS-CDSs to hedge against the bubble bursting — but do you really think that ACA and the German bank thought their counterparties wore hard hats to work ? No they thought that their counterparties were irrational type 4 traders.
It is obvious that the synthetic CDO market was type 4 Wobegone finance. The Case-Shiller assets are better for hedging of all risk except specifically for RMBS default risk which can be completely hedged with only non-synthetic CDOs. Basically ACA had to know that their counterparties were someone like Paulson.
Now there was fraud all right. ACA didn’t know that their counterparty was uhm helping them choose underlying assets for the synthetic CDO. However, if they thought they were selling insurance, then they were dangerous fools such that taking their money is a public service.
In fact, I think the fraud was a public service. If people who think they are smarter than average decide that maybe Goldman-Sachs is defrauding them, then there will be less speculation. I think that would be a very good thing. The reason is that I think type 4 trading reduces the valuable information in prices. The trades can’t exist in Nash equilibrium. Therefore finance theorists assume that there are some irrational traders. Then finance theorists (except for DeLong et al) assume that the volume of irrational trade is exogenous. They conclude that anything which causes high trading volume causes prices to be closer to fundamental values. That’s a pretty direct passage from an unjustified assumption to a conclusion. I think it is obvious that higher trading volume causes greater price volatility and that this volatility is always vastly greater than the volatility of fundamental values. So I think that, aside from not being an argument that type 4 trades are win-wins, your argument has it backwards. I think that real world type 4 trading reduces the information content of prices — because it is fundamentally irrational. So less of it would be better.
Goldman Sachs has damaged its reputation as a fair broker with this scam. I think that is an excellent thing, because that reputation caused people to trade if they thought they were smarter than average. Fear of being cheated by Goldman Sachs makes up for irrational over confidence and will lead the economy towards where it would be if everyone were rational. To put it briefly, what’s bad for Goldman Sachs is good for the world.